ATR - Reading Volatility in Numbers

What is ATR

ATR (Average True Range) is a technical indicator that quantifies market volatility. It was introduced by J. Welles Wilder in his 1978 book "New Concepts in Technical Trading Systems," the same book where he also published RSI.

The most important characteristic of ATR is that it doesn't indicate price direction. ATR only measures how much price is moving - the magnitude of volatility. A high ATR value means price is moving significantly; a low value means price is moving quietly.

How True Range is Calculated

To understand ATR, you first need to understand the concept of TR (True Range). TR isn't simply the day's high minus low; it selects the largest of three values to account for gap situations.

True Range = Maximum of the following three values

1. Current High - Current Low
2. |Current High - Previous Close|
3. |Current Low - Previous Close|

Here's what each calculation means:

Absolute values are used because TR must always be positive. Volatility is a magnitude concept regardless of direction, so it cannot be negative.

Example Calculation

Let's calculate for a case where yesterday's close was $50,000, today's high is $53,000, and today's low is $49,000:

• Method 1: 53,000 - 49,000 = 4,000
• Method 2: |53,000 - 50,000| = 3,000
• Method 3: |49,000 - 50,000| = 1,000

The maximum of the three values, 4,000, becomes that day's True Range.

How ATR is Calculated

ATR is the average of True Range over N periods. The default period, as suggested by Wilder, is 14 days.

The first ATR value is simply the arithmetic mean of TR over 14 days:

First ATR = (TR1 + TR2 + ... + TR14) / 14

After that, a smoothing formula similar to exponential moving average (EMA) is used:

ATR = [(Previous ATR x 13) + Current TR] / 14

This approach gives more weight to recent data while not completely ignoring historical data - a balanced calculation method.

What ATR Tells You

Magnitude of Volatility

The ATR value itself represents volatility magnitude. If Bitcoin's ATR is $2,000, it means the average daily price movement over the past 14 days has been about $2,000.

Interpreting ATR Relatively

When ATR has been at low levels for an extended period and then rises sharply, it suggests a new trend is beginning. Conversely, when ATR peaks at an extreme high then begins falling, trend momentum may be exhausting.

Using ATR for Stop Loss Settings

ATR's most practical application is setting rational stop loss prices. Using a fixed percentage (e.g., -3%) means stops get hit too easily in volatile markets and are too loose in calm markets.

2x ATR Stop Loss Strategy

The most widely used method is setting the stop loss at 2 times ATR from the entry price.

Long Stop Loss = Entry Price - (2 x ATR) Short Stop Loss = Entry Price + (2 x ATR)

For example, if you bought Bitcoin at $60,000 and the current ATR(14) is $1,500, the stop loss would be 60,000 - (2 x 1,500) = $57,000.

ATR Trailing Stop

ATR-based trailing stops move the stop loss along with price as it moves favorably.

• Long position: Set stop at Recent High - (N x ATR), raising the stop as new highs are made.
• Short position: Set stop at Recent Low + (N x ATR), lowering the stop as new lows are made.

The advantage of this approach is automatic adaptation to market volatility. When volatility increases, stop width widens; when volatility decreases, stop width narrows.

Using ATR for Position Sizing

ATR is also used to determine appropriate investment amounts. The principle is to allocate smaller amounts to higher-volatility assets and larger amounts to lower-volatility assets.

Position Size = Risk Amount Allowed / (N x ATR)

For example, if you're willing to risk $1,000 per trade, Bitcoin's ATR is $20,000, and the multiplier (N) is 2, then position size would be 1,000 / (2 x 20,000) = 0.025 BTC.

Using this method keeps the dollar amount lost per stop loss consistent regardless of what asset you're trading. This is the position sizing technique used in the famous Turtle Trading system.

ATR Multiplier Comparison

ATR Characteristics in Cryptocurrency Markets

Cryptocurrency markets are inherently more volatile than traditional stock markets, so ATR values are naturally larger. This doesn't mean crypto is dangerous - it's an objective reflection that price movement ranges are wider.

In the 24/7/365 cryptocurrency market, gaps rarely occur, so Method 1 (Current High - Current Low) typically becomes the True Range in most cases. However, exchange maintenance or extreme events can cause gaps, so all three TR calculation methods remain relevant.

For cryptocurrency investors, it's effective to analyze volatility from multiple angles using ATR together with Bollinger Bands. While Bollinger Bands visualize standard deviation-based volatility, ATR provides absolute price movement as a number.

Cautions When Using ATR

First, ATR doesn't indicate direction. Rising ATR doesn't mean price is going up. ATR can increase during both uptrends and downtrends. Leave direction determination to trend indicators like moving averages and MACD.

Second, ATR is a lagging indicator. As an average of the past N periods, it shows the current volatility state rather than predicting future volatility.

Third, don't directly compare absolute ATR values between different assets. Comparing Bitcoin's ATR of $1,500 (with price at $60,000) to Ethereum's ATR of $100 (with price at $3,000) is meaningless. For comparisons, use percentage ATR (ATR divided by price).

Summary

ATR is a practical indicator that shows market volatility as an objective number. While it doesn't generate buy/sell signals on its own, it delivers significant value in the core risk management areas of stop loss setting and position sizing. Rather than making trading decisions based on a single indicator, ATR's true value emerges when used alongside other trend and momentum indicators, as discussed in multi-indicator strategies.

Next article: OBV - Confirming Trends Through Volume Flow